Thoughts on Commodity Management

Second only to oil, coffee is widely considered to be the most valuable legally traded commodity in the world, with an estimated 2.25 billion cups of coffee consumed worldwide every day. However, consistently high demand does not mean that coffee farmers, traders, buyers, and sellers are rolling in the beans. In fact, coffee has a history of significant price volatility that has greatly affected the ability of market participants to turn a profit.

According to Fairtrade International, this volatility spurred the creation of the first International Coffee Agreement in 1962, which was designed to stabilize the market by introducing quotas to withhold excessive coffee supplies. In 1994, a new version of this agreement stipulated that prices would no longer be regulated, and that same year, prices escalated to a high of $2.80 per pound thanks to a frost threatening crops in Brazil. Then in 2001, coffee prices fell to a thirty year low of $.45 per pound almost overnight due to overproduction, devastating farmers and putting many out of business.

Fast forward to 2011, when prices climbed to a 14-year high, spurring growers to expand coffee-growing lands and plant high-yielding tree varieties. Because of this, we are now experiencing what the Wall Street Journal calls the biggest coffee bust in over a decade due to overproduction. Arabica coffee on the ICE Futures U.S. exchange recently fell to their lowest levels since September 2009.

In order to maintain profit margins amidst never ending volatility, companies engaged in the buying, trading, and selling of coffee must have sophisticated commodity trading and risk management (CTRM) solutions providing business intelligence and analysis tools that enable smarter decisions, minimize risk, and optimize supply chain management. Spreadsheets do not provide the sophisticated functionality needed for maximizing efficiency and profitability in today’s unpredictable environment.
Coffee & Cocoa International has published an article featuring Triple Point’s Brian Seidman, VP, Solutions Director, Agriculture, exploring these very issues. It discusses how companies including Armajaro Trading and Mercon Coffee Group are leveraging Triple Point’s Commodity XL for Agriculture solution to mitigate market risk, maximize profitability, and achieve optimized supply chain management. Read it now.

Just a few years back, there were many articles discussing “Peak Oil” and whether the world had already passed the peak. A typical headline was one in Fortune Magazine in 2008 with a headline predicting a dramatic increase in oil prices – “Here comes $500 oil.”

At the recent HIS CERA Week, it was reported that “Peak Oil” was already a distant thought for most presenters, and that much of the talk was about growth in natural gas and oil from unconventional shale resources in the U.S.

According to the U.S. Energy Information Administration (EIA), crude oil production in the U.S. exceeded an average seven million barrels per day (bbl/d) in November and December of 2012, the highest volume since December 1992.

The International Energy Agency (IEA) predicts that the United States will overtake Saudi Arabia and Russia to become the world's leading oil producer by 2017.

The WSJ MarketBeat Blog notes we are only at the beginning. “U.S. tinkerers discovered a way to extract oil and gas from shale, the source rock for oil and gas that was previously deemed uneconomical. That has boosted U.S. production to levels not seen in two decades, and that’s only the beginning: shale recovery factors could improve, and vast shale formations in Argentina, China, Russia and other countries are yet to be tapped. If technology ever allows the industry to recover 70% of oil from conventional reservoirs and to double or triple the current recovery rate from unconventional resources, the world could almost quadruple the reserves of global liquids.”

In addition, Iraq passed a critical milestone last year by producing three million barrels a day of crude oil for the first time since before the Persian Gulf War, reaching a high of 3.4 million bbl/d in December. Given its access to vast reserves at low costs, Iraq could play a significant role in the growth of energy supply. Of course, in Iraq there is much geopolitical risk attached to supply.

Even with increased production, there was still not enough oil to meet demand in the beginning of 2013. The EIA estimates a 1.3 million bbl/d average draw-down in global oil stocks for January and February.

There are numerous uncertainties as we move forward including the rate of technology advancements, geopolitical risk in many energy rich nations, growth in demand as the world continues its economic recovery, etc. Perhaps the only certainty is continued volatility and the need for oil trading risk management software to manage the volatility.

As Jim Rogers, Chairman, President, and CEO of Duke Energy has been known to express in speeches, “Ben Franklin said there are two certainties in life: death and taxes. To that, I would add the price volatility of natural gas.”

The energy industry and its associated supply chains are fast-changing and very complex. Just a few years back, several companies built LNG import terminals to meet the energy needs of the U.S.

According to a NY Times article “the billion-dollar terminals were obsolete even before the concrete was dry as an unexpected drilling boom in new shale fields from Pennsylvania to Texas produced a glut of cheap domestic natural gas. Now, the same companies that had such high hopes for imports are proposing to salvage those white elephants by spending billions more to convert them into terminals to export some of the nation’s extra gas to Asia and Europe, where gas is roughly triple the American price.”

Currently there are 25 LNG-importing countries in Europe, Asia, South America, Central America, North America and the Middle East, up from 17 importing countries in 2007.

Cheniere’s Sabine Pass LNG Terminal in Louisiana was the first to receive approval to export LNG. According to Steven Chu, the U.S. Energy Secretary, "Our long term economic strength depends on safely and responsibly harnessing America's domestic energy resources while developing new and innovative clean energy technologies. This project reflects a broad, 'all of the above' approach that will put Americans to work producing the energy the world needs."

The open question is whether this a good investment, or is the market changing so rapidly that the investment in LNG export terminals will also be obsolete before the terminals are fully functional? The same NY Times article mentions, “countries around the world are importing drilling expertise and equipment in hopes of cracking open their own gas reserves through the same techniques of hydraulic fracturing and horizontal drilling that unleashed shale gas production in the United States. Demand for American gas — which would be shipped in a condensed form called liquefied natural gas, or LNG — could easily taper off by the time the new export terminals really get going, some energy specialists say.”

Whether it’s Crude, LNG, Natural Gas, Power, Biofuels or other energy commodities, the common denominator is volatility and complex supply chains. The combination of volatility and complexity is the reason Triple Point’s ETRM (energy trading and risk management) software has been in great demand over the last five years. Energy companies that have not invested in sophisticated ETRM software have put their businesses at a competitive disadvantage.

The gas in our cars, cleaning chemicals in our cabinets, and reusable cups from which we drink our coffee or tea all have ties to the crude oil industry. As feedstock for a wide array of goods, crude oil and crude products are among the most widely traded commodities in the world. The market attracts diverse participants; however, many of the challenges faced are universal.

CommodityPoint’s latest white paper, “Global Oil Markets- Increasing Uncertainty and Risk,” highlights several of these challenges and concludes that now is the time to invest in an advanced energy trading and risk management (ETRM) software solution to combat rising volatility.

This white paper discusses how the political unrest affecting many of the world’s crude-producing regions is having a direct effect on oil supply. Tensions in the Middle East threaten to shut down the busiest port in the region, which could interrupt the delivery of 17MMbbl/day. Should this situation come to fruition, market volatility will be further exacerbated, and those companies that are not properly equipped to manage it will suffer.

While the threat of a continued reduction in crude supply looms, crude demand continues to grow each year. CommodityPoint’s paper suggests the only way to effectively navigate the market fluctuations caused by scenarios such as this is to implement a sophisticated trading solution that can not only capture, manage, and value trades and hedge positions; but that can also model the entirety of the physical operations of market positions. Read the paper now and find out why it’s imperative to have an ETRM solution such as Commodity XL™ that provides an integrated, real-time view of physical and financial exposure alongside operational, credit and regulatory risk exposure.

The US Midwest is suffering its worst drought in decades. The US Department of Agriculture (USDA) recently dropped its corn yield forecast from 166 bushels per acre, made earlier this year, to 123 bushels per acre. The expected shortage of corn is causing prices to surge.

Corn has multiple uses – it is used as fuel (ethanol), animal feed, or directly as food. Roughly 40% of US corn production goes towards ethanol, 36% towards feed, and the rest towards food.

There are several concerned groups that believe the Environmental Protection Agency (EPA) should relax the ethanol requirement under the Federal Renewable Fuels Standard act, which states that there must be 13.2 billion gallons of corn starch-derived biofuel produced in 2012. The UN has called for an immediate suspension of the US-mandated use of ethanol. In addition, a coalition of beef, pork, and poultry producer associations have called for a cessation of the ethanol requirement.

Whether the EPA will ease the ethanol requirement is not the most important question – the real question is how do we plan to deal with rising agricultural commodity prices and volatility in the long term? The corn shortage might be a one season event, but volatile agriculture and softs prices are here for the long term.

We have an expanding world population that is forecasted to grow from 7 billion to 10 billion in the next 35+ years. As part of this population growth, there is a rapidly growing middle class across China, India, and other parts of Asia. China and India alone are doubling their per capita incomes at approximately 10 times the rate and 200 times the scale achieved by Britain’s Industrial Revolution in the 1800s. This growing middle class wants to eat higher on the protein scale (more meat which needs more animal feed). And it appears we’ve hit a pattern of severe weather events including droughts, floods, extreme temperatures, etc. These long term trends will drive acute commodity price swings – which is, as we’ve said before, the new normal.

All companies in the food supply chain, from upstream to downstream, should be putting plans and commodity risk management systems in place to handle price volatility.

There have been several recent announcements from Delta Airlines related to jet fuel and oil trading.

According to Reuters, Delta Air Lines Inc. reported a second quarter loss because it took $561 million in charges for fuel hedges. Part of the loss was taken for mark-to-market adjustments on open hedge contracts.

It appears that Delta has chosen not to apply FAS commodity hedge accounting treatment. Many of the news reports called these derivative purchases “bets” when in fact they are hedges that reduce risk.

If Delta used hedge accounting it would match the loss of open fuel derivative contracts against future jet fuel purchases and not show the loss in the current period. Hedge accounting is extremely complex, and an advanced, auditable software system is required to support the adoption of these procedures.

Separately but related to managing fuel cost and risk, Delta announced that it completed its acquisition of the Trainer Refinery in Pennsylvania through its Monroe Energy subsidiary. Delta will move jet fuel from the refinery to its hub airports in the Northeast. Additional refined products such as gasoline and diesel fuels will be traded for jet fuel in other parts of the country. Delta spent about $12 billion on jet fuel in 2011 and expects to serve 80% of its domestic jet fuel needs from the Trainer refinery and related deals.

Delta is the first airline to own refining capacity. It will be interesting to observe if other airlines follow suit and move to vertically integrate their energy supply chains.

Supplying a refinery with crude oil and trading products requires sophisticated energy trading and risk management (ETRM) software. With volatility seemingly increasing daily in the commodity and crude oil markets, it seems prudent for Delta to invest in a hedge accounting and oil trading and risk management platform.

Four years ago Triple Point acquired INSSINC, the leading commodity hedge accounting software solution, and integrated it into its energy trading and risk management (ETRM) software solution. At that time, Triple Point recognized the need for an integrated commodity management platform that seamlessly integrates all key risk areas.

The new volatility reality demands that all industries with exposure to commodities and energy review their current risk systems to ensure they are appropriately protected.

According to McKinsey, Asia’s global middle class is likely to grow by three billion people over the next 20 years, and China and India are doubling per capita incomes by approximately 10 times the rate and 200 times the scale achieved by England’s Industrial Revolution in the 1800s.

This massive middle class expansion has fueled demand for commodities such as oil, coal, and wheat. More and more Commodity Management companies dealing in the Asia Pacific (APAC) region are realizing that in order to ensure price volatility doesn’t diminish profitability, they need advanced technology solutions such as Triple Point’s Commodity XL™ to optimize supply chains, improve decision-making, and minimize risk.

In 2011 Triple Point experienced record growth in APAC, with year-over-year revenue for the region increasing 75%. APAC customers include China National Offshore Oil Corporation (CNOOC) Limited, China’s largest producer of offshore crude oil and natural gas, as well as Bayin Resources, Dhanlaxmi Bank, Marubeni, Merit Chartering, and State Bank of India. Triple Point has also significantly expanded its staff in Asia Pacific, growing from 250 to over 400 employees, in order to ensure full support for the company’s growing customer base. In addition, Triple Point extended its Asia Pacific footprint with the acquisition of QMASTOR, the premier provider of mining software solutions, headquartered in Newcastle, Australia.

In our circles, when we talk about the Dodd-Frank Act, we tend to gravitate our conversations to Title VII – Wall Street Transparency & Accountability. It is, of course, the most hotly disputed, high profile part of the legislation. So, it’s easy to forget some of the other sections of DFA that may concern corporations. One such section is 1502.

Section 1502 – Conflict Minerals

This section requires a disclosure that on the surface seems fairly well intended. Since Congress has determined that “the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo and adjoining countries is helping to finance conflict characterized by extreme levels of violence in the eastern Democratic Republic of the Congo, particularly sexual- and gender-based violence, and contributing to an emergency humanitarian situation”, corporations will be required to disclose their sources of “Conflict Minerals”. Conflict Minerals include columbite-tantalite (coltan, niobium, and tantalum), cassiterite (tin), gold and wolframite (tungsten) and their derivatives. The State Department can add new minerals when they determine it is necessary.

Who will be impacted?

The impact will be broad, and will encompass all publicly traded companies that source the listed minerals. If you think about it, that covers quite a cross-section of industries: automotive, communications, electronics – you name it. By the SEC’s own estimates, at least 6,000 companies will be impacted. They will be required to disclose in their 10-K, 20-F and 40-F filings the use of “Conflict Minerals” in their products. Even if the source of the material cannot be established, that will also require disclosure. Lacking a de minimis provision in the law, any sourced quantity will necessitate disclosure. The law also calls for due diligence, although that has not been entirely defined. In all likelihood the model of due diligence proposed by Organization for Economic Co-operation and Development (OECD), would serve as a template.

Court of Public Opinion

There are problems with distilling the complex problems of the Democratic Republic of the Congo to a sourcing disclosure and expecting it to be the solution. There are legitimate tribal mining operations that are likely to suffer as a result of this requirement. Regions of the DRC are not in conflict, but they are already witnessing the impact of the proposed rulemaking. According to a recent New York Times article, many mining operations in Eastern Congo have been damped or halted completely. And so the SEC struggles – delaying its final rulemaking yet again. With no established SEC guidelines, I would anticipate more mining operations to close. The concern among manufacturers is also heightened, and it is not just a cost of compliance issue. The fear is that the public’s perception will drive investment or product purchase decisions based solely on a DRC tag or a lack of traceability. Keep in mind, the legislation does not make it illegal to source Conflict Minerals, it just requires the disclosure of that information. I’m all for doing the right thing here, but I’m just not entirely convinced that this is the right thing. Not for the people of the DRC or the corporate world.

If you get the feeling that we’ve been here before, you’re right. I’m talking about the convergence efforts of the two accounting standards organizations - FASB and IASB. After all, they have been at it for nearly ten years, so the probability of my addressing it at one time or another are quite high. Well, at the end of January the two boards renewed their efforts to find common ground in the development of standards and disclosure requirements. “The boards have been urged to converge their standards on financial instruments. Today's decision to work together on key differences—which represent the most significant remaining differences between the decisions reached to date—is responsive to stakeholders in the US and abroad”, said FASB Chairman Leslie Seidman. A commitment with a rhyme - what could go wrong?

As an optimist, I want to believe that it can happen, and there certainly are signs that indicate that it just might come to fruition. Of course, if you’re a pessimist, you are just as likely to find many signs to indicate that it won’t happen. If the renewed talks aren’t enough evidence for you, then you may want to consider a staff paper that the SEC issued back in May, 2011, titled “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers”. That paper explores the incorporation of IFRS, and is essentially an approach combining elements of convergence and endorsement, thus coining the now popular phrase, “Condorsement”. With an endorsement approach, jurisdictions would simply incorporate an individual IFRS standard into their standards, while a convergence approach keeps local standard and attempts converge them with IFRS. The condorsment approach suggests a phased one, where the scheduled convergence projects continue to move forward while seeking areas where endorsements of individual IFRS make sense.

The concept of allowing corporations to adopt IFRS reporting is not that new. It was first pitched in 2008 by then SEC Chairman Christopher Cox, and there now seems to be some serious momentum behind the proposal. Even though the SEC recently delayed its decision on the topic, IASB Chairman Hans Hoogervorst remains confident that SEC will ultimately decide to go with IFRS. In a recent speech given at an Ernst & Young IFRS seminar in Moscow, Hoogervorst stated, “The US already has developed a sophisticated set of financial reporting standards over many decades. Transitional concerns have to be carefully considered. That is why I have supported the general approach for the endorsement of IFRSs described by the SEC staff’s work plan. It is also important to note that the US is committed to supporting global accounting standards. It is SEC policy, it is US Government policy and it is the policy of the G20, in which the US is a key player. “

Most of the G20 member countries currently require the use of IFRS. Also, more than a hundred countries globally currently allow or require IFRS reporting. Detractors call IFRS Euro-centric. I find that interesting, since much of the seeding for the standards in IFRS were a result of groundwork laid out by FASB. In a global economy, it is essential that we end up with a uniform approach. So let’s keep it moving along - make it international and rational. I love rhymes.

Deloitte just released an outstanding report, Tracking the Trends 2012, on the top 10 issues mining companies may face in the coming year. Some of the top challenges include rising capital costs, commodity price chaos, government taxes, and growing labor shortages. Many of these issues have a familiar ring. However, the Deloitte reports warns that: “The factors influencing the global mining industry are moving to a new level of extremity.”

The report is full of practical suggestions to tackle the top challenges, including new strategies to:

Bring costs under control

Manage commodity price volatility

Improve capital project management

Attract financing

Mitigate the risks of diversification and

Plan for unforeseeable amid greater volatility

Other key takeaways include:

Many opportunities remain to use automation as a tool to fight cost inflation

Key challenges have reached a new level of extremity and require improved collaboration across the entire global enterprise

Vale, Rio Tinto, American Anglo, and many other leading mining companies are fostering improved collaboration by using Triple Point’s end-to-end mining software solution, QMASTOR Pit-to-Port, to provide an integrated view of their global supply chain. This enables them to improve operations and maximize profit through efficient use of resources. What are you doing to ensure consistent practices and communication across your entire global enterprise? Could an integrated view of your mining operations drive profits to a new level in 2012 and beyond?